aggregate demand Flashcards
Why is the aggregate demand curve downward sloping?
a fall in the price level increases the quantity of real GDP demanded
Aggregate demand and aggregate supply model
A model that explains short- run fluctuations in real GDP and the price level.
why AD curve is downward sloping
The wealth effect: Consumption
how does inflation affect wealth?
Some household wealth is held in cash or other nominal assets that lose value as the price level rises and gain value as the price level falls.
- if you have $10 000 in cash, a 10 per cent increase in the price level will reduce the purchasing power of that cash by 10 per cent.
- When the price level rises the real value of household wealth declines, and so will consumption.
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what is the wealth affect
mpact of the price level on consumption
interest-rate effect,
impact of the price level on investment
what are 3 reasons why AD curve is downard sloping
- wealth effect
- interest-rate effect
- international-trade effect
explain the interest rate effect
- When prices rise, households and firms need more funds to finance buying and selling –> households and firms try to increase the amount of funds they hold by withdrawing funds from banks, borrowing from banks or selling financial assets, such as bond –> interest rate charged on bank loans and the interest rate on bonds increase –> higher interest rate raises the cost of borrowing for firms and households –> firms will borrow less to build new factories or to install new machinery and equipment, and households will borrow less to buy new houses.
caveat to interest rate effect
Lenders to banks and other financial institutions—people with savings are the lenders—will have their wealth increased as the interest rate rises, and will increase their consumption spending.
explain the international-trade effect
If the price level in Australia rises relative to the price levels in other countries, Australian exports will become relatively less profitable to produce compared to those produced for the domestic market, and foreign imports will become relatively less expensive.
- Australian imports will rise and export earnings will fall, causing net exports to fall.
to understand why AD is downward sloping, what assumption do we have
We begin with the assumption that government purchases are determined by the policy decisions of politicians and are not affected by changes in the price level.
The variables that cause the AD curve to shift fall into three categories:
1 Changes in government policies
2 Changes in the expectations of households and firms
3 Changes in foreign variables
Changes in government policies
- Fiscal policy:
- Gov purchases is a component of AD. increase in gov purchases –> AD shifts to right
- Increase in personal taxes –> reduce after-tax income of households –> reduced consumption –> AD shifts to left
- RBA tightening or loosening the monetary policy
Changes in the expectations of households and firms shift AD
If households become more optimistic about their future incomes they are likely to increase their current consumptio – > AD shifts to right
Firms become more optimistic about the future profitability –> AD will shift to the left
describe how changes in foreign variables can shift the AD
- Economic growth in Australia and other countires
- Exchange rate
Why is the SRAS curve downward sloping?
as the price level increases the quantity of goods and services firms are willing to supply will increase
The main reason firms are willing to supply more goods and services as the price level rises is that,
as prices of final goods and services rise, prices of inputs—such as the wages of workers or the price of natural resources—rise slower
Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs.
Therefore, a higher price level leads to higher profits and increases the willingness of firms to supply more goods and services.
describe the secondary reasons that SRAS is downward sloping
firm that is slow to raise its prices when the price level is increasing may find its sales increasing and therefore will increase production.
A firm that is slow to reduce its prices when the price level is decreasing may find its sales falling and therefore will decrease production.
Why do some firms adjust prices more slowly than others, and why might the wages of workers and the prices of other inputs change more slowly than the prices of final goods and services?
Most economists believe that the explanation is that some firms and workers fail to predict accurately changes in the price level. If firms and workers could predict the future price level exactly, the SRAS curve would be the same as the LRAS curve.
what are the 3 explanatoins as to how the failure of workers and firms to predict the price level accurately result in an upward-sloping SRAS curve
Economists are not in complete agreement on this point, but we can briefly discuss the three most common explanations:
1 Contracts make some wages and prices ‘sticky’.
2 Firms are often slow to adjust wages.
3 Menu costs make some prices sticky.
how does the failure of workers and firms to predict the price level accurately result in an upward-sloping SRAS curve?
Contracts make some wages and prices ‘sticky’
when are prices and wages ‘sticky’? how does this lead to higher output
Prices or wages are said to be ‘sticky’ when they do not respond quickly to changes in demand or supply. Fixed contracts can make wages or prices sticky.
rising prices lead to higher output
example of how fixed contracts can make wages and prices sticky
a building company negotiates a three-year contract with its workers through an enterprise bargain with the unions at a time when demand for buildings is increasing slowly.
after the contract is signed the demand for new building starts to increase rapidly and prices of new buildings rise.
The company will find that producing more buildings will be profitable, because it can increase prices while the wages it pays its workers are fixed by contract.
steelworks company might have signed a multi-year contract to buy iron-ore (which is used in making steel) at a time when the demand for steel is stagnant. If steel demand and steel prices begin to rise rapidly, producing additional steel will be profitable because iron-ore prices will remain fixed by the contract.
Contracts makes wages and prices sticky
the workers at the building company or the managers of the iron-ore companies had accurately predicted what would happen to prices
this prediction would have been reflected in the contracts, and the building and steelworks companies would not have earned greater profits when prices rose. In that case, rising prices would not have led to higher output.
firms are slow to adjust to wages is another reason why failure of workers and firms to predict the price level accurately result in an upward-sloping SRAS curve
describe
wages of many workers remain fixed by contract for one year or even several years
firms are unlikely to change the salary until the contract expires
If firms adjust wages only slowly, a rise in the price level will increase the profitability of hiring more workers and producing more output. A fall in the price level will decrease the profitability of hiring more workers and producing more output.
menu costs making price sticky is another explanation for a higher price level leading to a larger quantity of goods and services supplied.
describe
firms face menu costs (costs of changing prices)
unexpected increase in the price level –> firms will want to increase the prices they charge
BUT Some firms,may not be willing to increase prices because of menu costs. Because of their relatively low prices, these firms will find their sales increasing, which will cause them to increase output.
Variables that shift the short-run aggregate supply curve
- Expected changes in the future price level
- Adjustments of workers and firms to errors in past expectations about
the price level
- Unexpected changes in the price of an important natural resource
how can expected changes in the price level shift SRAS?
if workers believe that inflation will increase, then they will demand for higher wages so that their real wages won’t fall
how can Adjustments of workers and firms to errors in past expectations about the price level shift SRAS?
Workers and firms sometimes make incorrect predictions about the price level. As time passes they will attempt to compensate for these errors.
e.g.
the unions sign a contract with a building company that contains only small wage increases because the company and the union expect only small increases in the price level. If increases in the price level turn out to be unexpectedly large, the union will take this into account when negotiating the next contract. The higher wages the workers receive under the new contract will increase the company’s costs and result in the company needing to receive higher prices to produce the same level of output.
how can Unexpected changes in the price of an important natural resource shift the SRAS?
when there is a supply shock (an unexpected event causing supply curve to shift)
supply shocks usually caused by increases or decreases in natural resources’ prices
prices of natural resources are volatile e.g. oil
oil is used in the production process –> oil price rises unexpectedly –> production costs rise if used in production OR petrol price rises –> transportation cost rise
Variables that shift the short-run and long-run aggregate supply curves
what are they?
increases in the labour force and in the capital stock and resources:
- firms will supply more output at every price level
- in Japan, labour force is shrinking due to agining population –> SR and LR AS shifts to the left
Technological change
- technological changes makes workers and machinery more productive –> increase in unit of output per unit of input
- production costs fall –> produce more output at every price level
workers and firms adjusting to having previously under- estimated the price level
what happens to SRAS curve
shifts to the left as workers and firms increase wages and prices
Because equilibrium occurs at a point along the LRAS curve we know the economy
is at potential GDP: firms will be operating at their normal level of capacity, and there will be full employment
The short-run effect of a decline in aggregate demand
describe this graph
in the short run
- in the SR, AD shifts to the left –> new SR macroeconomic equilibrium is BELOW POTENTIAL GDP so profits declines, workers are laid off i.e. recession
The short-run effect of a decline in aggregate demand
describe this graph
in the long run
Workers and firms will begin to adjust to the price level being lower than they had expected it to be (workers will accept lower wages, firms accept lower prices)
particularly b/c unemployment –> willing to accept lower wages and decline in demand –> willing to accept lower prices
shifts to the right back to potential GDP in the long-run
long-run effect of a decline in aggregate demand
describe this graph
how long does it take for an economy to return to potential GDP
may take several years
long-run effect of a decline in aggregate demand
Economists refer to the process of adjustment back to potential GDP just described as
why?
an automatic mechanism b/c no actions by the gov is required
alternatively, policies such as monetary and fiscal can restore actual, real GDP to potential GDP
The short-run effect of an increase in aggregate demand
economy will be above potential GDP : firm operating above normal capacity and above full employment
- some re-enter the labour force and some workers work overtime
what is the long-run of effect of an increase in aggregate demand
automatic mechanisms will bring the economy back to potential GDP
Workers and firms will begin to adjust to the price level being higher than they had expected.
- Workers will push for higher wages—because each dollar of wages is able to buy fewer goods and services— and firms will charge higher prices.
- In addition, the low levels of unemployment resulting from the expansion will make it easier for workers to negotiate for higher wages, and the increase in demand will make it easier for firms to receive higher prices.
The short-run effect of a supply shock
what is a supply shock
what is the short-run effect?
supply shock occurs when there is an unexpected event that causes an increase in the costs of production,
causes a recession –> unemployment increases
The short-run effect of a supply shock
examples of supply shock and what does it lead to
increase in import prices, a natural disaster or if wage rates rise faster than productivity growth rates.
This leads to the occurrence of cost-push inflation, which as we saw in is a rise in the general price level due to a supply shock
the short-run effect of a supply shock
what is stagflation
A combination of inflation
and recession, usually
resulting from a supply
shock.
i.e. rise in price level and fall in real GDP
the short-run effect of a supply shock
draw
draw the LR effect of supply shock
describe the long run effect of supply shock
but how long would this take? what is an alternative?
workers are willing to accept lower wages and firms are willing to accept lower prices as employment rises and output falls
may take years for this process to be completed
Monetary or fiscal policy will bring the economy back to potential GDP faster BY SHIFTING AD TO THE RIGHT, but this would result to a permanently higher price level
DYNAMIC AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL
describe
incorporates the following important macroeconomic facts:
1 Potential GDP increases continually, shifting the LRAS curve to the right.
2 During most years the AD curve shifts to the right.
3 Except during periods when workers and firms expect high rates of inflation, the SRAS
curve shifts to the right.
draw the basic aggretate demand and supply model
Dynamic aggregate demand supply model
why does LRAS shift to the right?
during the year potential GDP increases as the labour force and capital stock increase and technological progress occurs.
dynamic aggregate demand and supply model
why does SRAS curve shift to the right?
when labour force and capital stock increases + technological change occurs —> increase the quantity of goods and services that firms are willing to supply in the short run
dynamic AD and AS curve
why does AD shift to the right
b/c as population grows and incomes increase, consumption will rise over time
As the economy grows firms will expand capacity and new firms will be formed, increasing investment.
An expanding population and an expanding economy require increased government services, such as more police officers and teachers, so government purchases will increase.
dynamic AD and AS curve
why is there no inflation
aggregate demand and aggregate supply shifted to the right by exactly as much as long-run aggregate supply
dynamic AD and AS curve
why would we expect there to be inflation?
SRAS curve is affected by workers’ and firms’ expectations of future changes in the price level and by supply shock –> partially, or completely, offset the normal tendency of the SRAS curve to shift right
consumers, firms and the government may cut back on expenditures. This reduced spending will result in the AD curve shifting to the right less than it normally would or, possibly shifting to the left
dynamic AD and AS model
If total spending in the economy grows faster than total production, prices rise how is this illustrated?
AD curve shifts to the right by more than the LRAS curve
dynamic AD and AS model
why has SRAS curve has shifted to the right by less than the LRAS curve
the anticipated increase in prices offsets some of the technological change and increases in the labour force and capital stock that occur during the year
what happens if aggregate demand increased by the same amount as short-run and long-run aggregate supply
illustrate
price level will not change
experience economic growth without inflation
b/c total spending growing at the same pace as total production
explain this graph
LRAS1973 and LRAS1974 are at the levels of potential GDP for each year.
Macroeconomic equilibrium for 1973 occurs where the AD curve intersects the SRAS1973 curve, with real GDP of $342.8 billion and a price level of 21.5.
Macroeconomic equilibrium for 1974 occurs where the AD curve intersects the SRAS1974 curve, with real GDP of $341.9 billion and a price level of 25.0. (shifted to the left b/c of large supply shock)
what is AS
effect of changes in the price level on the quantity of goods and services that firms are willing and able to supply.
What is potential GDP
When firms are operating at their normal capacity and there is full employment
Why is long-run aggregate supply (LRAS) curve a vertical line at the level of potential GDP? (short run aggregulate supply is upward facing)
Because Changes in the price level do not affect the level of aggregate supply in the long run.
real GDP is always at its potential level and is unaffected by the price level
What would shift the long-run aggregate supply curve?
- 1 An increase in resources, such as migrant workers or new mineral discoveries, in the economy.
- 2 An increase in the quantity of machinery and equipment used in production.
- 3 New technology or more productive ways of using resources.
what does short-run aggregate demand and aggregate supply model enables us to explain
The aggregate demand and aggregate supply model enables us to explain short-run fluctuations in real GDP and the price level.
AD curve is downward sloping because
a decline in the price level causes consumption, investment and net exports to increase
The short-run aggregate supply curve slopes upwards because
workers and firms fail to predict accurately the future price level
